| 25 September 2008
Making sense of the looming economic “crisis” may be a bit difficult for the average American. What’s worse is the fact that most of us hear the word “crisis” and react without discerning for ourselves whether the severity of the situation is accurately described. So what exactly is this crisis and what is this $750B bailout?
Before we look in to whether or not there is truly a crisis we should first understand exactly what is going on. If you listened to G.W. Bush’s speech the other night he offered a pretty laymen explanation. He is an expert in simplifying things. Basically Bush said that citizens took out loans that they could not repay. This is an oversimplification. How can someone taken out a bad load cause a crisis for me? It’s their house, car or personal property that’s going to be reposed. Sucks for them right?
The expression “take out a loan” itself is inaccurate. You don’t take out a loan. You ask for a loan and hopefully the bank (or other financial institution) gives you a loan. Herein lay the first problem. Over the past ten years Americans have been qualifying for loans they really can not afford. Therefore the blame not only falls on the citizens for accepting the loans but also on the loan officers for approving folks for bad loans. When the loan later defaults the bank is left holding the worthless note.
Why were bad loans given out to the point where regional and national institutions are now failing? The answer to that question requires a long discussion on financial instruments and markets. The short story is that, once the loans are made they can be sold to other entities. For example, I could loan you $1,000 and expect payments over time that would eventually result in you paying me back the initial $1,000 as well as $500 in interest. Instead of waiting for you to pay me those cash flows on a monthly basis over time, I can sell the rights to those payments (the note or loan) to a third party at a discount; perhaps $1,250.
In real world terms this is where the problem begins. Institutions made as many loans as they could for the simple fact that they knew there was always a buyer for the note. Fannie Mae and Freddie Mac existed for the sole purpose of buying mortgages from lenders. Their buying the mortgages allows the initial lender to go back and offer more mortgages – bad or good. Keep in mind that foreign governments also buy the loans and not just mortgages.
Once Fannie and Freddie began to look bad because the loans were defaulting, the world market lost confidence in the US housing market as a whole. Once there is no one to buy the loans, lenders start to get tighter with their lending – referred to as the Credit Crunch. These lenders also wind up holding on to a lot of bad loans since they can not sell them. Eventually they don’t have money to lend because no money is coming end. The result is failure.
This brings us to up to date on where we are today. The $750 bailout is where congress uses taxpayer’s money to go and buy up all the bad loans lenders are sitting on. That injects cash and liquidity in to the market so lenders can continue to make money by doing what they do – offering loans.
G.W. may have been correct in saying that the system is broken but he is unfairly placing the blame on America’s citizens for accepting loans they could not repay. The fact is that the players in the financials were making big money and getting fat off lending the money to any and everyone. No company should be bailed out. That is capitalism. Companies that run inefficiently are rewarded with failure. Economic Darwinism. Survival of the fittest.
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